Short sellers ducking for cover has sent stocks ripping higher in the last 2 days

The recent stock market rally has been all about short sellers running for cover.

Over the course of Friday and Tuesday’s trading action, the S&P 500 gained 3.6% while the Russell 3000 — a broader index of small-, medium-, and large-cap stocks — rallied 4.6%.

And according to an analysis from the team at Bespoke, the biggest gains by far have been from stocks that heading into the last two days were among the most shorted (or stocks investors are betting will go down in price).

In the last two trading days, the 300 most heavily shorted stocks are up 6.5% while the least heavily shorted stocks are up 3.5% on average. As of late January, investor bets against stock prices were at their highest level in six years.

It’s an old market axiom that every decline in the stock market is investors taking profits on their winners with every rally the result of short-sellers getting squeezed out. And while this is probably always partly true and mostly not, the case that the action we’ve seen over the last couple days in the market is in fact a short squeeze is about as compelling as it gets.

As for what this means for stocks in the coming days, here’s Bespoke (emphasis ours):

It’s impossible to call a bottom until it’s well into the rear-view mirror, and most bottoms are immediately followed by short covering like we’ve seen over the last two days. However, bounces during downtrends also see heavy short covering, and eventually the market rolls over again. The bottom line is that it’s simply too early to tell if the lows put in last Thursday will ultimately establish a much longer-term low, and anyone that has come out and called a bottom really has no idea. While there have been some early signs of stabilisation, for now the market still remains in a relatively steep downtrend, and thus we’d caution against jumping back in heavily on the long side.